Limits To Arbitrage
The efficient market hypothesis predicts that prices reflect fundamental value. Why? People are greedy, and any mispricings are immediately corrected by those smart, savvy investors who can make a quick profit.
But in today’s world of instant information, supercomputers and interconnected markets, true arbitrage—profits earned with zero risk after all possible costs—rarely, if ever, exists. Most arbitrage has limits in the form of some cost or risk.
Let’s look at a simple example.
Oranges in Florida cost $1 each.
- Oranges in California cost $2 each.
- The fundamental value of an orange is $1 (assumption for the example).
- The efficient market hypothesis suggests arbitrageurs will buy in Florida and sell in California until California oranges cost $1.
But what if it costs $1 to ship oranges from Florida to California? Prices are decidedly not correct—the fundamental value of an orange is $1. But there is no free lunch since the frictional costs (of shipping an orange) are a limit to arbitrage. In short, the smart, savvy arbitrageurs are prevented from exploiting the opportunity (in this case, due to frictional costs).
News flash: Humans beings are not rational 100 percent of the time. To anyone who has been married, driven without wearing a seat belt, or hit the snooze button on their alarm clock, this should be pretty clear. And the literature from top psychologists is overwhelming for remaining naysayers. Daniel Kahneman, the Nobel-prize winning psychologist, and author of the New York Times best-seller, Thinking, Fast and Slow, tells a story of two modes of thinking: System 1 and System 2.
System 1 is the “think fast, survive in the jungle” portion of the human brain. When you start to run away from a poisonous snake (even if later on, it turns out to be a stick), you are relying on your trusty System 1.
System 2 is the analytic and calculating portion of the brain that is slower, but 100 percent rational. When you are comparing the cost benefits of refinancing your mortgage, you are likely using System 2. Importantly, we do not always use System 2, even when we should; for instance, when making investment decisions.
Now, let’s combine our wacky investors (System 1 types) with the limits of arbitrage that we discussed above (it is costly in some way for smart people to take advantage of wacky investors). Combining price-influencing bad behaviors with costly arbitrage restrictions creates an interesting field of study that academics refer to as “behavioral finance.”
And while this working definition of behavioral finance may seem simple, the debate surrounding behavioral finance is far from settled. In one corner, the efficient market clergy claims that behavioral finance is heresy, reserved for those economists who have lost their way from the “truth.” They point to the evidence that active managers can’t beat the market and incorrectly conclude that prices are always efficient as a result.
In the other corner, practitioners who leverage “behavioral bias” suggest that they have an edge because they exploit investors who are acting irrationally. Yet practitioners who make this claim often have terrible performance.